Spain Not Greece Is the Real Test for the European Union

By the Editors -
Apr 4, 2012

The decisive test of the euro area’s
plans for economic recovery was never Greece but Spain, and the
European Union shows every sign of failing it.

The Spanish government’s new austerity plan hasn’t won
investors’ confidence, and this creates a threat not just to
Spain but to the whole EU. Europe’s governments need to change
course before it’s too late.

An auction of Spanish bonds on Wednesday was the first
verdict on Spain’s new budget. It didn’t go well. Demand was
poor and prices fell. The country’s borrowing costs rose with 10
year bond yields in the secondary market hitting 5.7 percent,
the highest since the beginning of the year. The premium over
German government bonds increased to nearly four percentage
points, the highest since November.

The problem is not that Spain’s new austerity plan is too
timid. Just the opposite: Under EU orders, Spain is promising
what might be the tightest fiscal squeeze that it or any other
European economy has ever faced. The new plan calls for the
budget deficit to fall from 8.5 percent of gross domestic
product to 5.3 percent this year. Since the economy is already
shrinking, this requires a discretionary fiscal tightening of
roughly 4 percent of GDP -- with the unemployment rate already
standing at about 23 percent.

Lost Ground

Spain overshot its previous too-demanding fiscal targets,
and is being told to make up lost ground. It missed its budget
goal because regional governments, over which Madrid has limited
control, failed to do their part, while economic growth came in
lower than expected. This is all too likely to happen again.
Excessive austerity stamps on growth, which causes public
borrowing to rise despite the government’s efforts. The
government’s new plans are simply not credible: The more it
succeeds in cutting public spending, the worse the outlook for
growth and hence for public debt.

Spain’s overall unemployment rate is terrible enough, but
the youth unemployment rate is an amazing 50 percent. Recession
isn’t the only cause. The country’s labor market, divided by
Franco-era rules between an absurdly protected sector for long-
term employees and a lightly regulated sector for those on
temporary contracts, has long been seen as one of the most
dysfunctional in the developed world. The government’s efforts
to reform it are necessary and long overdue -- but it’s hard to
win support for reforms that will cause further labor-market
disruption at a time like this. The new center-right government,
in office barely three months, is facing strikes and just lost a
regional election it expected to win. As well as losing the
confidence of the markets, it may already be losing the
confidence of voters.

The Greek economy is tiny, but Spain’s is the fourth
largest in the euro area. If it goes down it will take the EU’s
still-puny defenses against such an eventuality down with it.
The European Central Bank’s long-term liquidity operations,
which have let banks borrow roughly 1 trillion euros on easy
terms, have lately helped to stabilize financial conditions, but
Spain’s worsening predicament shows this was a false dawn.

Spain cannot work through this crisis without more help
from its EU partners. In their own larger interests they should
allow a milder path of fiscal consolidation, and support Spanish
growth along that path. That means steps to buoy EU-wide growth,
including easier fiscal policy in Germany and easier monetary
policy from the ECB. It means outright temporary fiscal
transfers to Spain. Above all it means announcing that the ECB
will act as lender of last resort to distressed euro-area
governments.

Spain is being drawn into a vicious circle of economic,
fiscal and political collapse. Even now, this is an avoidable
danger, so long as the EU is willing to act. But if it stands
aside too long and lets Spain fall into the trap, containing the
damage will make dealing with Greece look like child’s play.